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Ask TheStreet: Valuations

Ask TheStreet is designed to answer questions about the market, strategies, and investment methods. Please email us to ask a question, but keep in mind that we cannot offer specific investment advice.

Reader: Please help me to understand how P/E ratios are established. If a company earns X in a given year, how does the market determine the company's future earnings potential? And, if a company reports somewhat disappointing earnings in a given quarter, how are the adjustments to potential growth calculated? --P.D.

Gregg Greenberg: Your first question is the easiest to answer because it's just a matter of simple math. After that, things, as they tend to do on Wall Street, get a bit fuzzy.

A company's P/E, or "price-to-earnings" ratio, is established by dividing the current share price by the annual earnings per share. Some investors prefer to use the "12-month trailing" earnings in the denominator, because that's actual earnings, while others prefer using "forward" earnings estimates.

It's in the use of forward earnings estimates where things start to get hairy.

Forward estimates are educated guesses made by Wall Street analysts as to a company's earnings per share for an upcoming quarter or fiscal year. The analysts' guesses can be considered "educated" because they are often guided by the companies themselves. Each Wall Street analyst creates his or her own set of forward estimates, then a service like Thomson First Call takes the average of the expectations.

Finally, on D-day, when a company reports its actual earnings for the quarter, both the analysts and the company are put to the test. If the company's profits fail to match or beat the average earnings estimate, the stock usually gets creamed. That's called a "negative surprise." If a company "beats" estimates it's called an "upside surprise" and the stock more often than not heads higher.

(If a particular analyst is way off in his estimate, and continues to be wrong quarter after quarter, then you may want to look for another analyst, and he may want to look for another job.)
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